The Jayson Law Group LLC previously published an article about the differences between general corporations and LLCs.  We elected not to discuss S Corporations at the time, due to their complexity. In this two-part article our business attorneys attempts to simplify S Corporations and boil them down to the basics. At The Jayson Law Group LLC, we want businesses and those looking to start a business to be informed.

S Corporations: What Are They?

S Corporations are a business entity which lets you enjoy the limited liability of a corporate shareholder, while still paying income taxes as if you were a sole proprietor or partnership. Let us explain—in a regular corporation (C corporation) the owners are taxed only on their income (salary, bonuses, or dividends) received from the corporation, while the business itself is taxed on its own profits. In S corporations, though, the business profits “pass through” to the owners to claim on individual taxes while the business does not pay its own income taxes.

Here is an example of the difference between a C Corporation and an S Corporation from a tax perspective as discussed above:

Widget Company is owned by 5 shareholders: Adam, Barry, Cliff, Dave, and Evan.  Each shareholder is a 20% shareholder in Widget Corporation.  In Fiscal Year 2013 Widget Company nets $5,000,000.00 (5 million).  The share structure and compensation structure is designed so that each shareholder is paid only in salary.  How much will each shareholder earn after paying taxes?  In this example we will use 40% is the corporate tax rate and 35% is the individual tax rate.

If Widget Company is a C Corporation, the taxes are as follows:

• Widget Company pays $2,000,000.00 (2 Million) in tax (5 Million X 40%);
• This leaves $3,000,000.00 (3 Million) for the Company distribute equally to the 5 shareholders;
• Each shareholder will receive $600,000.00 as salary;
• Each shareholder will pay $210,000 in tax ($600,000 X 35%);
• Therefore, each shareholder will net $390,000 in after tax income

If Widget Company is an S Corporation, the taxes are as follows:

• Widget Company pays NO tax on the $5,000,000.00 (5 Million) (in an S Corporation the business is not taxed);
• This leaves $5,000,000.00 for the company to distribute equally to the 5 shareholders;
• Each shareholder will receive $1,000,000.00 (1 Million) as salary
• Each shareholder will pay $350,000 in tax (1 Million X 35%)
• Therefore, each shareholder will net $650,000 in after tax income

This means that there is a difference of $260,000 in after tax income for the shareholder, depending on whether the corporation they own is a C corporation or an S corporation.

IRS Red Flags

Owners of S Corporations needs to be careful.  The IRS is looking for self employed individuals that create S Corporations in order to avoid self employment tax.  S Corporations must pay the owner a fair salary in order to avoid an audit.  If for example the S Corporation has a profit of $100,000.00 ($100 Thousand) and it pays the owner a minimal salary of $5,000 for the year and the owners pays a $95,000 distribution to him or herself, that taxpayer is avoiding medicare and social security taxes on the $95,000 which can add up to thousands of dollars.

Why Elect S Corporation Status?

Apart from a tax advantage, there are some of the other advantages of an S Corporation as compared to a C Corporation.

• S Corporation status allows you to pass on business losses to your personal income, so you can use it to offset any income you (or your spouse) have from other sources.
• Upon selling your S corporation, your taxable gain on the sale can be less than if you had operated as a regular corporation.
• S corporation shareholders are not subject to self-employment taxes (like LLC owners), which dedicate sometimes more than 15% of your income to Medicare and Social Security taxes.

 Are There Any Limitations on an S Corporation?

• While there are some enticing benefits to S corporation status, aside from tax advantages, there are still some limitations as opposed to a C corporation.S corporation shareholders must be U.S. citizens or residents.
• S corporations are limited to 100 or fewer shareholders.
• An S corporation shareholder can only deduct a portion of corporate losses—the amount of his or her “basis” in corporate stock (their investment plus or minus a few adjustments).
• S corporations cannot deduct the fringe benefits provided to an employee-stockholder who owns more than 2% of the corporation.

How to Elect S Corporation Status

First, you must create a corporation by filing the necessary Articles of Incorporation with the Secretary of State’s, office or New Jersey’s Corporation Division. Then, all shareholders must sign and file IRS Form 2553 in order to create an S corporation. If, for whatever reason, it becomes more advantageous, you can drop your S corporation status after a certain amount of time.

There are several options available when it comes to building a business. The New Jersey business attorneys at Jayson Law Group are experienced business advocates and counselors. We provide services from business formation and dissolution, to mergers and acquisitions.

Email or call us today at (908) 258-0621 for a consultation.